Financial crises - whether global or specific to a sector such as housing or infrastructure - cause bank loans to turn sour. Many borrowers, who were advanced dollops of bank credit in heady times, are neither able to complete their projects nor sell their assets. Without sufficient earnings, they start defaulting on their interest and principal payments. Consequently, hitherto good assets in a bank's loan book become non-performing assets (NPA).
How these NPAs are treated depends upon the asset and income recognition norms set out by a country's central bank. In most cases, a few rules are sacrosanct. From the time a loan becomes an NPA - generally after a grace period of 90 days from the due date - a bank can no longer accrue interest on the outstanding portion. It must also make appropriate provisions. In India, a secured term loan that remains an NPA for up to a year is called a 'sub-standard' asset on which 15 per cent of the outstanding dues must be deducted (or provided for) in the bank's profit and loss account. After a year, it becomes a 'doubtful' asset on which the provisioning scales up from 25 per cent in the first such year to 50 per cent in the second and 100 per cent in the third. Thereafter it becomes a 'loss' asset, which must be fully provided for.
Naturally, banks hate NPAs because these hurt their profit and loss account and balance sheet. Only few have strong enough financials to take the hits without flinching. Hence, banks fudge in one admissible way or the other. Since a rolling loan gathers no loss, a typical method is to persuade the borrower to pay some of his dues so that the account can be maintained as 'regular'. The other, though less popular, way is through a central bank-sanctified 'one-time debt restructuring' which, in India, is called corporate debt restructuring. In any event, the truth is that, with few exceptions, the extent of NPAs is under-reported.
When NPAs burgeon, as these have in India today, or did during the US 'savings and loan' crisis of the late 1980s, the Swedish banking crisis of 1991-92 or the Iceland bank crisis of 2008-11, ARCs come into play. ARCs offer to buy 'bad loans' at steep discounts with the expectation that the assets can be either turned around or appropriately restructured and then hived off to others. It is a risky business. For ARCs to succeed, there are some inviolable conditions that must be followed.
Even if it was available at an attractive discount, buying an NPA that involves a company with a shady promoter will only bring grief. This is particularly true of term loans that are secured by plant and equipment or by first charge on toll receipts. Since the bulk of India's NPAs relate to infrastructure, especially power plants and highways, and since many of these were projects floated by promoters who don't believe that bank loans need to be repaid, an ARC picking up such assets is asking for trouble - most of all from the promoters and their lawyers. Years may pass with many court appearances and no resolution whatsoever.
The loan being offered to an ARC must carry a steep discount. As mentioned earlier, banks are loath to fully provision their NPAs because of what it does to their financials. Therefore, such loans are 'over-valued'. That raises two problems. First, it makes the loan unattractive to an ARC. Second, it raises accounting issues for the selling bank. For example, how does a public sector bank chief explain to the vigilance authorities that a loan, which was 20 per cent provided for, is now being sold at a discount of another 30 per cent to an ARC?
No ARC worth its name will hold a 'bad loan' to maturity. The rationale of an ARC is to buy attractive, but clean, assets; do some quick restructuring of the financials; and sell these at profits to risk-taking buyers. 'Bad banks' don't sit with bad loans. If they did, they would be dead on the water.
Good ARC managers are different from traditional bankers. They are sharp; look for good buying opportunities; get the best financial and legal brains to deconstruct the bought assets into unencumbered saleable parts; and sell these at profits as soon as possible. It is risk-taking that is fundamentally different from those known to bankers.
What do these rules imply for Indian ARCs? It is this: it is safe to pick distressed housing mortgage loans and sell these off to others, as the US-based ARCs did during the savings and loan crunch, or the Swedes and Icelanders did during their banking crises. However, very few housing mortgages in India default because that is the last thing an Indian will do. Equally, buying distressed term loans involving power, highways and other infrastructure is hugely risky and almost impossible to split and de-leverage into saleable parts.
Therefore, so long as we have laws such as the Sick Industrial Companies Act, the Board for Industrial and Financial Reconstruction and one of the world's worst bankruptcy resolution processes, we shouldn't expect ARCs to appear like white knights and save banks from their large NPAs. As things stand, ARCs are a sideshow. No bank can think of these as panacea to their ills.
The writer is an economist and chairman of CERG Advisory Private Limited